WeWork may not have been able to complete its once-planned IPO, but even so it now has something that many IPO companies often experience – a shareholder class action lawsuit. On November 4, 2019, a WeWork investor filed a lawsuit in California state court on behalf the company’s minority shareholders as well as on behalf of the company itself. As discussed below, the shareholder complaint makes a number of interesting allegations and raises some interesting issues as well.

Background

WeWork is a real estate and office share company. It was founded in 2010. Among its founders was Adam Neumann, who until recently served as WeWork’s CEO. At one time the company had over 5,000 employees and facilities in over 200 locations around the world. One of the company’s major investors is SoftBank, the multinational investment company led by Masayoshi Son.

In January 2019, WeWork announced that it was rebranding itself as The We Company and stated its valuation as $47 billion. In August 2019, the company announced its plans to go public. The company immediately drew sharp public criticism for its governance, share structure, and finances, among many other things. In September 2019, the company pulled its plan offering. Shortly thereafter, Neumann resigned his CEO position. At the same time, SoftBank agreed to take a controlling position in the company in a transaction that valued the company at about $8 billion.

As part of Neumann’s termination package, he was given the right to sell a portion of his shares, worth over $900 million, at the transaction’s valuation, as part of the planned tender offer. SoftBank also agreed to repay a $500 million loan from JPMorgan (the bank that had been picked to lead the company’s IPO). The bank also agreed to pay him a $185 million consulting fee. The Wall Street Journal estimated the total value of his package at $1.7 billion; the paper also called the package a “windfall.”

The Lawsuit

On November 4, 2019, a WeWork investor filed a lawsuit in California (San Francisco County) Superior Court against Neumann, WeWork’s board of directors, and SoftBank. The complaint, a copy of which can be found here, asserts both class action claims on behalf of the company’s minority shareholders and derivative claims on behalf of the company itself. The complaint asserts claims for breach of fiduciary duty, aiding and abetting breach of fiduciary duty, corporate waste, as well as for declaratory and injunctive relief.

The gist of the complaint is that Neumann, in concert with SoftBank, used their control of the company to the benefit of themselves and to the detriment of the minority shareholders and of the company, and that the company’s board aided and abetted this alleged misconduct.

The complaint specifically alleges that Neumann abused his control to extract benefits with a total value of $1.7 billion. SoftBank allegedly will benefit from its position in the planned transaction that will allow the company to obtain majority control of the company at a share price depressed by the defendants’ wrongdoing. The offering share price, the complaint alleges, is “grossly unfair” and represents both “an abuse of control” by Neumann and SoftBank and “unfair treatment of minority shareholders.”

The complaint also references in detail Neumann’s termination package, noting among other things that the valuation Neumann will get for his shares is superior to the consideration being offered to the minority shareholders. The complaint is also highly critical of Neumann’s $185 million “consulting fee,” which the complaint says “simply represents self-dealing and an improper personal payment to Neumann.”

The complaint seeks unspecified damages, and also seeks to block WeWork and SoftBank from further buybacks of minority shareholders’ shares.

Discussion

The new WeWork lawsuit is interesting and noteworthy largely because of the massive publicity that surrounded the company, its founder, and the company’s failed attempt to go public. The lawsuit seems like the latest act in the unfolding morality play in which the company has recently been involved.

There undoubtedly are many lessons from WeWork’s dramatic fall. At a minimum, the company is the latest example of the so-called Unicorns – privately held companies with massive valuations – that has fallen from its lofty heights.

WeWork is also the latest of the formerly high-flying private companies to get with a shareholder lawsuit. An earlier example of this phenomenon was Theranos, another formerly high-flying company that, though a private company, was hit with an investor fraud lawsuit. The lawsuits filed against both of these companies. The lawsuits are a reminder that even private companies can get hit with shareholder litigation – including, in WeWork’s case, investor class action litigation. The WeWork lawsuit may not allege violations of the securities laws, but it does represent a class action lawsuit – even though WeWork was and is a privately-held company.

There probably is a lot more that can be said for investment firms that pump massive amounts of money into what are essentially start-up companies, driving for ever loftier valuations, rather than economically viable enterprises. I will leave to others to try to sort out the issues and conclusions under that heading.

For those of us active in the management liability field, the circumstances – and in particular, the new lawsuit – are interesting for what it may say more generally about private company management liability. To be sure, WeWork may represent its own unique set of circumstances. Its size, the characteristics of its CEO, and other attributes of the company may make it unrepresentative concerning the risks private companies in general. Nevertheless, the circumstances and the lawsuit do provide an example of how a private company can become involved in shareholder litigation, and in this case, a shareholder class action lawsuit. Private companies can, and sometimes do, face very serious claims, and among them are claims brought by shareholders.

One final note about this lawsuit. While there is a lot going on here, and while the events that occurred after the company withdrew its IPO initiative, at one level this lawsuit is a failure to launch claim. Among the claimant’s grievances is the company’s failure to complete the IPO. This aspect of the case is a reminder that a lot can happen to companies on an IPO track, and if a would-be IPO company hits an obstacle and fails to complete the hoped-for offering, the company can get hit was a failure to launch lawsuit. This is important to remember because in that situation, the D&O insurance policy that will respond to the claim (and indeed the D&O insurance policy that will be responding to WeWork’s new lawsuit) is a private company D&O insurance policy. The possibility of these kinds of lawsuits is important to take into account when the pre-IPO company’s insurance coverage is being structured. Among other things, the policy’s Securities Claim exclusion must be worded in a way that it does not preclude coverage for these kinds of claims.

It remains to be seen who this claim will fare, but it is and will be a very interesting claim.

The D&O Diary is on assignment in Europe this week, with the first stop on the itinerary in London. I have been to London in November many times before and I know that the weather can be OK or it can be lousy. On this trip, I had a pretty even mixture of both. But even if there were no single full day of sunshine, there was also no single entirely rainy day. In between the intermittent rain, I had several chances to enjoy some late fall sunshine in London.

I had a full roster of meetings in London but my schedule did allow some time for to walk about a little bit as well. As always when I visit London, I make it my mission only to try to do things I haven’t done on a prior visit. London is such an amazing place that despite many prior visits, I am still finding new things to do.

Though I always aim to try new things while in London, there are certain other things that I also try to do every time I visit the city. One of these is things is to visit walk through Green Park. I was fortunate to enjoy an afternoon of autumnal sunshine for my visit to Green Park on this trip.

In keeping with my mission of only visiting new places, one early morning before the first of that day’s meetings I went to visit the Handel/Hendrix museum. As it turns out, in a wild and improbable coincidence, during the 60’s, Jimi Hendrix lived in the house in London in which Georg Frederich Handel had lived during the 18th century. The museum, which is located just off Bond Street, recreates the living spaces of each of the two musicians. It is a crazy concept for a museum, but it actually works. I enjoyed both parts of the museum, each in its own way.

The front view of the Handel/Hendrix Museum, just off Bond Street. It is an odd concept for a museum, but somehow it just works.

Another place I visited for the first time on this trip was the London Silver Vaults. Located on Chancery Lane in Holborn, the Vaults originally were built as a safe underground shelter for family silver, jewelry and furnishings, but the Vault now hosts dozens of independent silver dealers. The amount of silver on display is really kind of dazzling. The silver on display includes both antique and contemporary pieces. The hushed atmosphere conveys an overwhelming sense of privilege and wealth. A singular place, to be sure. (Special thanks to a loyal reader for suggesting that I visit the Silver Vaults.)

More silver than you have seen in one place in your entire life.

The high point of my visit was a Royal Philharmonic Orchestra concert I attended at Cadogan Hall (pronounced “Kah-DOH-gun”) in Sloane Square. Cadogan Hall is an intimate jewel box of a music venue. It seats only 950, but it actually feels much smaller. The concert I attended was the first in a series of performances of the five Beethoven piano concertos that will be performed over the next year in anticipated of the 250th anniversary of Beethoven’s birth. At the Tuesday evening concert I attended, Elizabeth Sombart was the pianist in a performance of Beethoven’s Piano Concerto No. 1. My seat in the upper level was perfectly positioned to allow me to watch Sombart’s hands as she played the cadenzas. It was a truly extraordinary experience. To my London friends, I urge you to consider attending the future concerts scheduled in the series. The venue and the musicianship of the soloist and the ensemble make for a really special evening.

The main entrance to Cadogan Hall near Sloane Square

Cadogan Hall in an intimate, jewel-box of a concert venue. A really great place to watch a concert.

Before I headed into central London for my meetings last week, I spent the weekend in Richmond-upon-Thames, west of the central city. This is actually my third visit to Richmond. I visited for the first time in April 2019 and basically fell in love with the place. (I am not the only one with a special place in my heart for Richmond; just this Wednesday, Country Life magazine called Richmond “London’s prettiest spot.”) My prior visits had been short day trips and mostly consisted of walking along the Thames. This time, by staying overnight in Richmond itself, I made time to allow an opportunity to explore the vast Richmond Royal Park, the largest of the London royal parks. I spent several hours on Saturday in the par, some of it in the rain. However, in the early afternoon, the rain held off and I enjoyed a pleasant ramble around the grounds. The park is beautiful, and a day spent strolling through the vast grounds and then along the river is about as pleasant a way to spend a day as I can think of. There were sufficient periods of sunshine between the intermittent rain showers to make the outing enjoyable.

At over 2,300 acres, the Richmond Royal Park is vast. I was fortunate the day I visited as the rain that had been falling all morning gave way to broken afternoon sunshine. I walked for hours.

I was fortunate to catch a glimpse of the park’s famous red deer.

Actually, the park’s red deer are kind of abundant, and over the course of several hours walking, I saw many of them.

The next morning, after a day of intermittent rain, skies were clear for a brisk walk along the Thames. (Despite the clear morning skies, it was raining again by early afternoon.)

Another view of a morning walk along the Thames. The Thames is a tidal river and it is surprisingly important to monitor the tide schedule. When my wife and I were in Richmond in July, we were nearly cutoff upstream when the tides came rushing in and the river flooded the walkways.

A grey heron out looking for breakfast.

At the heart of Richmond is Richmond Green, an open space lines with beautiful homes and along a number of pubs.

On one side of Richmond Green is the last remaining vestige of the Richmond Royal Palace, Henry VII’s formerly vast estate. (The rest of the palace was destroyed during the Protectorate.)

Sunset in the Thames river valley

On Thursday, I was off on the Eurostar to Paris for more meetings there. Obviously it is always a pleasure to be able to visit Paris but I am increasingly becoming a huge fan of London. More and more, I feel at home walking the neighborhoods, riding the Underground, and enjoying the diverse and ever-changing street scene. It may have become a cliché over the years, but just the same I truly understand the sentiment of Samuel Johnson’s famous quip that “When a man is tired of London, he is tired of life; for there is in London all that life can afford.”

More Pictures of London:

A view of the central London skyline from Waterloo bridge. This view has changed quite a bit in recent years, almost all of the taller buildings are of very recent vintage.

Evening comes early in London this time of year. Here’s a late afternoon view of the sky, taken in The Boltons in South Kensington. It was raining just a few moments before I took this picture, and shortly afterwards as well.

Influencers, if you ever wished you had a handy brochure on how to make proper disclosures in your sponsored posts, you are in luck. On Tuesday, the FTC issued a new guide titled “Disclosures 101 for Social Media Influencers,” along with three videos, that lays out the agency’s guidelines for when and how influencers should disclose their connection to a brand. The principles are nothing new, but they are explained in a way that is straightforward and user-friendly, complete with hearts and thumbs-up emojis. Some of the principles that are covered include:

If you endorse a product on social media, you need to make it obvious when you have a relationship with the brand — whether it be a personal, family, employment, or financial relationship (eg., the brand pays you, or you get free or discounted products).

As an influencer, it is your responsibility to make endorsement disclosures and to be familiar with the FTC’s guidelines.

The disclosure should be hard to miss and placed within the sponsored post itself. It shouldn’t be mixed into a string of hashtags (for example, #Venable #AllAboutAdvertising #Ad #GOAT), and if the endorsement is in a picture or video format, the disclosure should be superimposed on the image itself and/or verbally disclosed throughout the footage.

The disclosure should be in simple and clear language. Terms like “ad,” “sponsored,” “BRAND Partner,” and “BRAND Ambassador” are OK; shorthand references (eg., “sp,” “spon,” or “collab”) and stand-alone terms (e.g., “thanks” or “ambassador”) are not OK.

Your post must be truthful. Don’t lie and say that you’ve tried a product when you haven’t actually tried it, or that a product is great if you thought it was terrible.

And although this isn’t mentioned in the guide, keep in mind that the FTC is “following” influencers closely, as evidenced by its previous warning letters and complaints, and now the publication of this guide. If you are an influencer, make sure to familiarize yourself with the agency’s rules; if you represent a brand that works with influencers, send them a copy of the guide and double-check that its principles are consistent with your own internal compliance policy. Doing so will help keep you and your influencers on the right side of the law — and on the right side of the FTC.

Scribner v. Wineinger, et al. affirms that acquisition of a Texas oil and gas leasehold by limitations is not defeated if the adverse possessor’s acknowledgement of a claimant’s title comes too late.

Transaction history

Scribner’s father conveyed all of the interest to his son by the “2002 Assignment” but Scribner was unaware of the instrument until 2016. (Thanks, Dad!) In 2010, the executor of the estate of the now-deceased father assigned the interest to Latigo. Scribner, ignorant of the windfall, didn’t claim ownership. By a series of assignments between 2010 and October 2016, Parra et al (including Wineinger) obtained the interest. During that time Parra and its predecessors operated the lease, received the revenue, and paid the taxes.

In June 2016, Elder, an attorney representing Parra, discovered the 2002 Assignment, and to cure the potential cloud on title asked him to execute an assignment into the then-current owners. Later that month Park asked Scribner’s wife to have her husband sign the assignment.

In 2018 Scribner sued Parra for trespass to try title, trespass to real property and conversion. Parra asserted perfection of title by adverse possession under the five-year statute and counterclaimed for trespass to try title, declaratory judgment, and suit to quiet title.

The question

Did acknowledgement of Scribner’s title defeat adverse possession? No. It was too late.

According to Parra, its predecessors acquired limitation title by adverse possession under the five-year statute. After tacking the periods of possession of their predecessors since April 2010, they had adversely possessed the lease by April 2015.

Scribner argued that Elder’s offer to buy the leasehold was an acknowledgement of title in Scribner that precluded limitations from running because the possession was not adverse to Scribner.

Adverse possession in Texas requires “an actual and visible appropriation of real property, commenced and continued under a claim of right that is inconsistent with and is hostile to the claim of another person[,]”.

An acknowledgement of title precludes limitations from running in favor of an adverse-possession claimant only if it occurs before limitations title is acquired. The so-called acknowledgments of Scribner’s title occurred in 2016, which was after April 2015, the date adverse possession was achieved by Parra’s predecessors. Because the limitations period had already run, the contacts didn’t preclude limitations title in Parra’s predecessors.

According to the court, a possessor’s claim of right does not satisfy the appropriation requirement of the five-year statute if the possessor doesn’t intend to appropriate the land, but instead intends to hold the land only until or unless the true owner appears. But Elder and Park contacting Scribner and his wife did not raise a fact question on whether the acknowledgments negated an intent to claim an interest adverse to Scribner.

Parra itself didn’t have possession of the interest until after the statutory period had run. The intent of Parra’s predecessors, who possessed the interest between April 2010 and April 2015, was relevant to whether the possession was adverse to Scribner. But they had already performed the acts necessary to establish adverse title before Parra knew about the break in the record title. The contacts of Elder and Parks had no bearing on the predecessors’ intent. The court found no evidence that Elder or Park had any affiliation with the predecesors.

The court decreed that Parra was the owner of the interest and declared the 2002 Assignment null and void.

While the most common type of whistleblower may be a disgruntled employee, others can be whistleblowers, too. And as a recent SEC enforcement action highlights, interfering with these others’ attempts to communicate with the SEC can violate the agency’s whistleblower protection rules. In an amended complaint filed on November 4, 2019 in a pending SEC enforcement action, the agency alleges that the defendant company and one of its principals violated the SEC’s whistleblower rules by requiring the company’s investors to enter agreements in which the investors agreed not to contact the SEC or other regulatory enforcement authorities. The SEC alleges that these actions violated the agency’s whistleblower rules. A copy of the SEC’s November 4, 2019 press release about the amended complaint can be found here.

Background

The SEC first sued online auction portal Collector’s Coffee and CEO Mykalai Kontilai in the Southern District of New York in May 2019, as discussed here. The SEC alleged that the defendants had misappropriated over $6 million of investor funds in a $23 million offering fraud.

As described in the agency’s November 4 press release to which I linked above, on November 4, 2019 the agency filed an amended complaint in the enforcement action. Among other things, in the amended complaint, the SEC alleged that the defendants had “unlawfully sought to prohibit their investors from reporting misconduct to the SEC and other governmental agencies.”

Specifically, the agency alleged that the defendants had “attempted to resolve investor allegations of wrongdoing by conditioning the return of investor money on the investors signing agreements prohibiting them from reporting potential securities law violations to law enforcement, including the SEC.” The amended complaint further alleges that the defendants “went so far as to sue two investors that they believed breached one of the illegal agreements.”

The amended complaint alleges that the defendants’ actions in attempting to constrain the investors from contacting or communicating with the SEC violated SEC Rule Section 240.21F-17, which provides in pertinent part that “No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement.”

The SEC’s amended complaint charges Collectors Café and Kontilai with violations of the antifraud and whistleblower provisions of the federal securities laws, seeking preliminary and permanent injunctions, disgorgement plus prejudgment interest, and penalties.

The SEC’s press release includes a statement from the head of the agency’s Denver regional office as saying “”We allege that the defendants attempted to cover up their fraud by holding investors’ money hostage until the investors signed agreements preventing them from seeking law enforcement intervention.”

The press release also contains a statement from the head of the SEC’s Office of the Whistleblower as saying “The SEC’s whistleblower protections broadly protect not just employees, but anyone who seeks to report potential securities law violations to the Commission.”

Discussion

The SEC’s whistleblower rules, as is the case in many whistleblower programs, provide strong protections for those who come forward to report violations of the law. Underlying these protections is a fundamental notion that the law needs to protect those who come forward to report legal violations. Within these protections is an even more basic idea that there is a basic interest in having legal violations reported to the enforcement authorities.

The SEC’s actions against the defendants in this case, as well as the agency officials’ statements in the press release, highlight the fact that employees are not the only individuals that the SEC rules protect; the rules, as the SEC’s head of the Office of the Whistleblower put it, protects “anyone who seeks to report potential securities law violations to the Commission.”

For anyone who reads the newspaper these days, whistleblowing is a hot topic these days (a point I emphasized in a recent review of a current book about whistleblowing, here). The SEC’s amended complaint in this case is a reminder that whistleblower protection is a basic part of any whistleblower program, and underneath this fundamental need to protect whistleblowers is the basic need for those who witness wrongdoing to be encouraged to come forward and report legal violations. As the basic facts in this case show, those who committed the wrongdoing may take extraordinary steps to try to prevent those with knowledge of wrongdoing from coming forward. The agency’s amended complaint is a reminder that the law prohibits any effort to impeded those with knowledge of wrongdoing from reporting the legal violations.

The 2019 Texas legislature enacted a new Property Code Section 5.152 to protect mineral and royalty owners from a certain species of fraudulent transactions perpetrated on trusting and/or naïve and/or out of state mineral owners. Ethan Wood and I wrote about the scam when it made its way into the courthouse.

How the scam worked

The grifter, fronting for a company with a name similar to a reputable operator, would approach the owner with an oil and gas “lease” of minerals or royalty that were already subject to an existing lease. Except that the lease was actually the sale of the mineral or royalty interest at a bargain price. The scammers would then invoke arbitration provisions they had written into the conveyance, and relying on the confidential nature of the arbitration process, would stifle publicity of the inevitable dispute.

Why were the grifters successful?

Because the aforesaid trusting and/or naïve and/or out-of-state mineral owners didn’t read what they sign or don’t seek competent advise before signing. This is an age-old phenomenon and will always be with us.

The fix

That scourge was addressed by new Section 5.152 which provides, in summary,

A conveyance of a mineral or royalty interest,

by an instrument that is presented by a person acquiring the interest,

that is titled as an oil and gas lease or royalty lease or similar words,

but has the effect of conveying permanently or for a term all of the owners mineral interest in land or a royalty interest in production covered by existing oil and gas lease,

must include on the first page of the instrument and on each subsequent page, in the equivalent of 14 point font, a conspicuous statement saying substantially these words in substantially this form “THIS IS NOT AN OIL AND GAS LEASE. YOU ARE SELLING ALL OR A PORTION OF YOU MINERAL OR ROYALTY INTERESTS IN [description of the property]”.

The law doesn’t apply to an instrument that grants an actual oil and gas lease or conveys a mineral royalty interest for a term and provides that the interest vests in possession after the expiration or termination of all or a portion of the interest conveyed by an existing oil and gas lease in effect at the time of the execution of the instrument (in short, a top lease).

A conveyance without this language is void.

A person cheated by the absence of this disclosure may recover royalties, interest, court costs, and attorney fees, in addition to any other remedies they may have.

The amendment applies to agreements entered into on or after September 1, 2019, the effective date of the Act.

Most public company D&O insurance policies provide coverage for the corporate entity only for “Securities Claims.” But what constitutes a “Securities Claim”? That is the question the Delaware Supreme Court addressed in a recent appeal of an insurance coverage dispute in which a bankruptcy trustee had sued Verizon for breach of fiduciary duty, unlawful payment of a dividend, and violation of the uniform fraudulent transfer act. The trial court had entered summary judgment for Verizon, ruling that the bankruptcy trustee’s claims represented “Securities Claims” within the meaning of the policy. In an October 31, 2019 decision (here), the Delaware Supreme Court reversed the lower court, ruling that the bankruptcy trustee’s claims were not Securities Claims within the meaning of the policy. As discussed below, the decision raises some interesting issues

The Underlying Claim

This insurance dispute arises out of Verizon’s 2006 spin-off of its electronic directories business into a standalone company called Idearc. Verizon transferred the directories business to Idearc in exchange for 146 million shares of Idearc common stock, $7.1 billion in Idearc debt, and $2.5 billion in cash. Verizon distributed the common stock to Verizon shareholders.

In 2009, Idearc filed for Chapter 11 bankruptcy. U.S. Bank, the Litigation Trustee in the bankruptcy filed a lawsuit against Verizon. U.S. Bank sought damages of approximately $14 billion from Verizon and related entities, as well from John Diercksen, a Verizon executive and Idearc’s sole director at the time of the spinoff. U.S Bank asserted three substantive claims: (1) breach of fiduciary duty; (2) payment of an unlawful dividend in violation of the Delaware Code; and (3) fraudulent transfer under the U.S. bankruptcy code and the Texas Uniform Fraudulent Transfer Act.

Verizon and the other defendants defended the U.S. Bank lawsuit for five years. The case ultimately was dismissed following a bench trial. The dismissal was affirmed on appeal. During the course of the trial and subsequent appeal, Verizon and Diercksen incurred defense cost of over $48 million.

The Insurance Issues

At the time of the spinoff, Verizon and Idearc purchased a D&O insurance program, consisting of a primary policy and three excess policies. Verizon provided notice of the U.S. Bank lawsuit to the primary insurer on the D&O insurance program. The insurer acknowledged that Dierckson’s defense costs would be covered (subject to the policy’s self-insured retention) but said that Verizon’s defense costs would not be paid because the primary policy provided coverage for the entity only for “Securities Claims” and the U.S. Bank complaint does not constitute a “Securities Claim” within the meaning of the primary policy.

The primary policy defines the term “Securities Claim” to mean a Claim against an insured:

(1) alleging a violation of any federal, state, local or foreign regulation, rule or statute regulating securities (including, but not limited to, the purchase or sale or offer or solicitation of an offer to purchase or sell securities) which is:

(a) brought by any person or entity alleging, arising out of, based upon or attributable to the purchase or sale or offer or solicitation of an offer to purchase or sell any securities of an Organization; (b) brought by a security holder of an Organization with respect to such security holder’s interest in securities of such Organization;

In 2014 Verizon filed an action in Delaware Superior Court seeking coverage for the defense expenses incurred in the U.S. Bank action. The parties filed cross-motions for summary judgment.

On the question of whether the U.S. Bank lawsuit was a “Securities Claim,” Verizon argued that the court should interpret the word “rule” in the definition of the term to include judicial rules of law or common law rules, such as those governing the conduct of fiduciaries, arguing that if a law “regulates securities” in that it much be followed to properly engage in a securities transaction, then any alleged violation of the law constituted a “Securities Claim.”

The insurers argued that “rules” and “regulations” referenced in the definition should be understood in the securities context to include only those laws issued by an administrative action of a legislative or regulatory body.

The Superior Court Ruling

As discussed here, in March 2017, Judge William C. Carpenter, Jr. granted the Verizon parties’ motion for summary judgment motion and denied the insurers’ summary judgment motion, ruling that the U.S. Bank lawsuit was a “Securities Claim” within the meaning of the primary policy’s definition, and therefore that the insurers’ are liable for the amounts Verizon incurred in defending the U.S. Bank lawsuit.

In ruling in Verizon’s favor, Judge Carpenter noted that each side had offered reasonable but conflicting interpretations of the term “Securities Claim.” Based on the rule of contra proferentum, Judge Carpenter interpreted “any … regulation, rule, or statute regulating securities” as “pertaining to the laws that one must follow when engaging in securities transaction.” He also found that the definition is so broad that it would “simply be inappropriate” to find that the underlying claims did not either allege, arise from, or were based on or attributable to the purchase or sale of securities.

The insurers appealed.

The October 31, 2019 Decision

In an October 31, 2019 opinion written for a unanimous three-judge panel by Justice Collins J. Seitz, Jr. , the Delaware Supreme Court reversed the lower court’s decision, holding that the U.S Bank action did not involve a “Securities Claim” within the meaning of the policies, and therefore that Verizon is not entitled to recover its defense expenses from the insurers.

In interpreting the definition of the term “Securities Claim,” the Court started with “the basic understanding” that the provision is “aimed at a particular area of the law, securities law, and not of general application to other areas of the law.” The regulations, rules, and statutes referenced in the provision must be those that “regulate securities” and therefore are not addressed to “common law or statutory laws outside the securities regulation area.” In addition, because the term “separately establishes a connection to a securities transaction, then regulations, rules, or statutes must be directed specifically towards securities laws for ‘regulating securities’ to have meaning in this definition.”

With these conclusions as the starting point for its analysis, the Court then looked that the three substantive areas alleged in the underlying U.S. Bank complaint.

First, with respect to the breach of fiduciary duty claims, the Supreme Court said that “these claims are not reasonably characterized as regulations, rules, or statutes. Instead they involve a common law duty that if breached, leads to liability.”

Next, the allegation of unlawful distribution of dividends involves statutory claims, but the statutes, the Court said, regulate dividends, not securities. “While it is possible to issue securities as a dividend, the fact that stock might be involved is incidental to the regulatory purpose of the statue,” which is to make sure that the issuance of dividends does not render the corporation insolvent. The relevant statutes “are not statutes ‘regulating securities.’”

Finally, the trustee’s fraudulent transfer claims, while based on statutes, were not statutes “specific to transfers involving securities.” The fraudulent transfer claims “are not specific to securities regulation, and do not fall within the definition of a Securities Claim under the policy.”

Discussion

The Supreme Court’s reversal of the Superior Court’s ruling is obviously a big win for the insurers. It is also a big loss for Verizon, which went from a position where its defense fees would be reimbursed by the insurers to a position where there is no insurance available at all.

As is always the case in insurance coverage disputes but as was particularly the case here, policy wording matters. In that regard, it was critical that the policy definition of “Securities Claim” did not contain language found in many policies to include within the definition claims alleging violation of “any law, regulation or rule, whether statutory or common law.” (It was in fact a point mentioned by the Superior Court level that the primary insurer whose policy was being interpreted had included this “common law” language in a prior version of its policy form).

Whether or not the language would have resulted in a different outcome here, it is in the best interests of policyholders for the term to be amended to include an express reference to claims asserted under common law. I want to emphasize that I am not suggesting anything about the policy language at issue in this case. D&O insurance policy language is almost always the subject of extensive negotiations, and wording available in one situation may not be available in another. That said, the preferred approach would be to have the definition of Securities Claim amended to include an express reference to claims under the “common law,” where that amendment is available, rather than to depend on a Court interpreting language without that reference in the way the Court did here.

There are other recurring issues that frequently arise under varying definitions of the Securities Claim. These other issues can involve which company’s securities are referenced, and even who the claimant is. I discussed these issues in detail in my blog post about the lower court ruling. Because these issues are not relevant to the Supreme Court’s decision, I do not review these issues again here, but instead refer readers to the discussion section of the blog post analyzing the lower court’s decision.

Have you renewed your DMCA Designated Agent designation with the Copyright Office yet? (If you are unfamiliar with a DMCA Designated Agent, read below for an explanation.) Any company that may have previously qualified for the safe harbor from liability for copyright infringement under Section 512 of the DMCA will lose any ability to claim this safe harbor if the company does not renew its designation of agent within three years of the last online filing (or amendment), assuming you did this correctly between December 1, 2016 and December 31, 2017.

In late 2016, the Copyright Office issued a rule that everyone needed to file new online Digital Millennium Copyright Act “DMCA” agent designations between December 1, 2016 and December 31, 2017. Any DMCA agent designations that were filed at the Copyright Office prior to December 31, 2016 expired on December 31, 2017 if not renewed online. If you did not file any new DMCA agent designation online between December 1, 2016 and December 31, 2017, then your designation has expired and your company would not qualify for the safe harbor under the DMCA. If applicable to you, your company should file one immediately and hope that you had no copyright liability exposure during the intervening time.

If you did file a new online designation of your DMCA agent between December 1, 2016 and December 31, 2017, then you are required to file a renewal within three years of the date you filed your original online designation (unless you already amended in the meantime, in which case your three-year clock runs again from the date you amended it). This means that many companies have these renewals due between December 1, 2019 and December 31, 2020, depending on when they filed the original online designation. Simply put, if you filed your online designation of agent December 15, 2016, then your renewal is due no later than December 15, 2019. If filed your designation of agent December 15, 2016, but then amended your online designation in the meantime on January 1, 2018, then your renewal is not due until January 1, 2021.

In case you are unfamiliar with these issues, here are the key points:

Under the U.S. copyright law, if a third party uploads or posts copyrighted material to your website, and the third party did not have authorization to do so from the copyright owner/exclusive licensee, your company can be held strictly liable for copyright infringement. Even if your company did not affirmatively place the material on your website, or know it was infringing.

(1) Designate, on your website in a publicly available location, an agent to receive notifications from third parties of claimed copyright infringement and include the name of the service provider, and the name, address, phone, fax, and email of the specific designated agent you have selected to receive notifications. (Practice tip: we recommend that you create a special email address that funnels to multiple personnel within your organization to increase the chances notifications are not missed in an otherwise full email box).

(2) Provide the U.S. Copyright Office with the required information for the designated agent. A number of court decisions have held that if you do not directly provide the U.S. Copyright Office with the required information about your designated agent, this is fatal to your request for a safe harbor from liability — period. This is the step that we find clients most often overlook.

(4) Respond expeditiously to any effective notifications, or “take down” notices you receive, as required by the statute. Because some notifications, and your response thereto, can be nuanced, we recommend you discuss with copyright counsel your own protocol for responding to these notifications.

What Action Should You Take?

First, we recommend you check the Copyright Office website and/or your records to make sure you filed your online designation in the first place. If not, do so immediately.

Second, check the date you filed your last online designation of DMCA agent, or amendment (note: this must have been done online as any previously filed paper designations are long expired). Make sure that you file a renewal within three years of that date. If you do not, your previous designation will expire and you will lose your ability to seek a safe harbor from liability.

Third, make sure you are following the steps enumerated above and that you educate your internal teams responsible for this function.

In its June 2017 decision in Kokesh v. SEC (discussed here), the U.S. Supreme Court held that disgorgement in an SEC enforcement action represents a “penalty,” and therefore a SEC enforcement action claim for disgorgement is subject to a five-year statute of limitation. In reaching this decision, the Court emphasized (in footnote 3 to the opinion) that it was only deciding the statute of limitations issue, and was emphatically not reaching the larger issue of whether the SEC has the proper authority to order disgorgement in enforcement proceeding.

Having previously reserved this larger question in Kokesh, the Court has now agreed to take up a case that will address head-on the question of whether the SEC has the authority to order a disgorgement. On November 1, 2019, the Court granted the petition for a writ of certiorari in the case of Liu v. SEC, which will require the Court to decide whether the SEC may seek may seek and obtain disgorgement from a court as “equitable relief” for a securities law violation even though the Supreme Court determined in Kokesh that disgorgement is a penalty. The Court’s November 1, 2019 order granting the writ of certiorari can be found here.

Background

The case now before the Supreme Court arises out of an enforcement action the SEC brought against Charles Liu and Xin Wang.

The two individuals had organized an EB-5 investment program, through which Chinese investors, in exchange for investment commitments, could obtain a U.S. Visa. The two ultimately raised $27 million from 50 Chinese investors. The investors were told that the money would be used to develop and build a cancer-treatment center. The center was never built. The SEC contends that a substantial amount of the funds raised wound up in the defendants’ overseas bank accounts.

In May 2016, the SEC filed an enforcement action against Liu and Wang. The district court ultimately ordered them to pay $26.7 million in disgorgement – virtually all the money they had raised – as well as a statutory penalty totaling over $8 million. In October 2018, the Ninth Circuit affirmed the district court.

In making this argument, the petitioners noted that under its statutory authority, the SEC, in pursuing an action to enforce the securities laws, may obtain only injunctive relief, equitable relief, or civil monetary penalties. Despite this limitation, the petitioners said, the SEC sought and the Court awarded disgorgement against them. In doing so, the district court relied on pre-Kokesh authority in which disgorgement was interpreted as a form of “equitable relief.”

According to the petitioner, this view of disgorgement as equitable relief “cannot survive this Court’s reasoning in Kokesh.” The Court’s logic in Kokesh, in which the concluded that disgorgement is a penalty, is contrary to the long-standing view pre-Kokesh, that disgorgement was remedial rather than punitive and therefore represents equitable relief. (In making this argument, the petitioners cite at length from a dissenting opinion written by then-Judge Kavanaugh prior to his arrival on the U.S. Supreme Court.)

The petitioners argue further that Congress never authorized SEC disgorgement authority, and that in light of the Supreme Court’s conclusion in Kokesh that disgorgement is a penalty, for the SEC to seek and obtain a disgorgement award exceeds its enforcement authority.

The SEC’s Opposition to the Cert Petition

In its opposition to the cert petition, the SEC raised a number of arguments. Among other things, the SEC argued that the agency’s disgorgement authority arises under its statutory authorization to seek “injunctive relief.” The SEC also argued that there is nothing about the Court’s decision in Kokesh holsinf that disgorgement represent a penalty that means that disgorgement cannot qualify as an equitable remedy. “A remedy,” the agency argued, “can qualify as a form of equitable relief even though it might also be considered ‘penal’ for some purposes.” Kokesh was a statute of limitations case, the agency argued, and the Kokesh Court’s holding that disgorgement constitutes a “penalty” within the meaning of the relevant statute of limitations is not inconsistent with the proposition that disgorgement represents a form of equitable relief.

Discussion

The Court will now take up the question it previously reserved in Kokesh. I have say after reviewing the record that the question of the SEC’s authority could not come up in a set of facts less sympathetic to the petitioners. These petitioners are not going to win over many hearts. That said, they do raise an interesting question; the question they raise is not just one that the Kokesh court declined to address but it is also one that it was clear during oral argument in Kokesh that troubled several members of the Court. (There is also that opinion by Kavanaugh when he was on the D.C. Circuit in which he said that if disgorgement was a interpreted to be a penalty it could overturn extensive precedent on the SEC’s remedial authority…)

It remains to be seen how the Court will rule on this case ; indeed, the Court has only just taken up the case, and the parties have yet to brief the case and to present their oral arguments.

Just the same it is always interesting when the Court takes up a case that presents the possibility of upsetting long-standing precedent and practices. The fact is that the outcome of any given Supreme Court case is whatever result five justices decide. This case may or may not conclude that the SEC lacks disgorgement authority, but the possibility that the Court could reach that result certainly raises the interest level for this case. In any event, it is going to be interesting when the Court take up a case that will address a question so fundamental to the SEC’s enforcement authority.

And of course, if the Court were to conclude that the SEC lacks disgorgement authority, what would that do to all of the pending cases in which the Court is seeking disgorgement? What it would do to prior cases in which the Court obtained disgorgement? And if the Court were to conclude that the agency lacks disgorgement authority, what it would it do to the SEC’s future enforcement actions and efforts?

Lots of interesting things to think about while this case unfolds… The case should be decided before the of the current term at the end of June 2020.

The length of the class period is one of the most significant variables in defining the make-up of the plaintiff class in securities class action litigation. As discussed in the following guest post from Nessim Mezrahi, the length of the class period not only affects the aggregate damages of the class but it also could be a key factor in the selection of the lead plaintiff. As a result, Mezrahi suggests, the length of the class period is a consideration that deserves greater attention. Mezrahi is cofounder and CEO of SAR, a securities class action data analytics and software company. A version of this article previously was published on Law 360. I would like to thank Nessim for allowing me to publish his article on this site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you would like to submit a guest post. Here is Nessim’s article.

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The class period interval in securities class actions that allege violations of the federal securities laws under Section 10(b) and 20(a) of the Securities Exchange Act of 1934 is the second most fundamental determinant of the magnitude of potential aggregate — or classwide — damages.

Undoubtedly, the first is the number of shares of common stock sold by participants in the market in response to an alleged corrective disclosure that is alleged to be related to a specific misstatement or omission disseminated by directors and officers.

The length of the class period not only affects the magnitude of potential aggregate damages, but is also a key factor affecting the selection of the proposed lead plaintiff that may represent a purported class of defrauded shareholders.

The federal court system has established specific lead plaintiff selection criteria that incentivize plaintiffs’ attorneys to claim alleged artificial inflationary periods that are aligned with the maximization of their clients’ losses in order to participate in potential rewards of successful securities class action litigation, which have become significant.[1]

Most courts consider: “(1) the total number of shares purchased during the class period; (2) the net shares purchases during the class period (in other words, the difference between the number of shares purchased and the number of shares sold during the class period); (3) the net funds expended during the class period (in other words, the difference between the amount spent to purchase shares and the amount received for the sale of shares during the class period); and (4) the approximate losses suffered.” … While courts differ on the precise weight to apply to each factor, most courts agree that the fourth factor—the approximate losses suffered—is the most salient factor in selecting the lead plaintiff.[2]

Based on the court’s implied emphasis on the fourth factor, some competing plaintiff firms may prioritize the selection of a class period interval that is based on the timing of when purchases and sales of their clients’ shares occurred in relation to the final corrective disclosure. “For the purpose of calculating losses in determining the proper lead plaintiff in securities class actions, the courts use the most inclusive Class Period,” Dow said.[3]

Because of the court’s emphasis on selecting a lead plaintiff with the greatest losses, class period interval determination by plaintiffs counsel may be unrelated to the timing of when the alleged fraud actually began. The start date of the class period is a key driver that is regularly used by plaintiffs to top the podium at the lead plaintiff contest.

Lead plaintiff competitions are not a race to the courthouse or a test of the fittest. They have become a race where the winner represents the biggest loser. Because of the court’s emphasis on proposed lead plaintiffs losses, the competition does not necessarily test which firm has applied the most rigorous and robust investigation of alleged malfeasance by directors and officers. The barriers to filing a securities class action for alleged Exchange Act violations have been lowered, and this presents greater risks for directors and officers of publicly traded companies.

Less established securities plaintiff firms have strong incentives to select a class period start date that fits with the potential clients that would yield them the greatest amount of alleged losses regardless of the strength of their internal investigation, if any. Established firms on the other hand, expend greater resources and engage in robust investigatory efforts with qualified in-house professionals that can attain indicative evidence of when a potential alleged violation of the federal securities laws began to take place.

An over-inclusive class period that backtracks through years of quarterly reporting periods will not only make scienter and loss causation allegations much harder to prove if a class is certified, but it may also artificially inflate potential classwide damages by attempting to allege that the fraud began much sooner than realistically possible.

Backtracking a class period start date over years of quarterly reporting periods without rigorous and verifiable investigatory work is akin to what fraud investigator Harry Markopolos attempted by alleging that a decade-long fraud was manifested by dozens of directors and officers across the globe at General Electric Co.[4]

The class period time frame is a powerful lever controlled by plaintiffs attorneys from the start of the action. This lever has a measurable and material effect on exposure, liability, potential damages, settlement ranges, shareholder recovery, defense fees and plaintiffs counsel award.

For example, in the securities class action In re General Electric Securities Litigation, the first complaint alleged that directors and officers began to misrepresent certain information related to the H-class gas turbine on Oct. 12, 2018.[5] The claim originally alleged a 2 ½- week class period with a single corrective disclosure, leading to a claimed exposure of $8.5 billion.

The first amended complaint subsequently claimed that the alleged fraud began almost three years ago, on Dec. 4, 2017. The amended claim alleged at least eight corrective disclosures that yield a claimed exposure of $33.2 billion.[6] In other words, during the pleading stages of the litigation — prior to the motion to dismiss — alleged exposure in this claim has increased by 290%.

A similar scenario is now playing out the Phillip Morris International Inc. Securities Litigation.[7] The first complaint alleged that directors and officers misrepresented information to investors during a two-month period starting on Feb. 8, 2018, with an initial exposure estimated at $24.6 billion stemming from a single alleged corrective disclosure.

In the current operative complaint, the plaintiffs’ counsel has expanded the class period by two years, and increased the number of alleged corrective disclosures to three. These changes have driven exposure up by 43% to $35.2 billion, while the class period end date remains the same.[8]

Initial exposure against these two corporate staples of the U.S. economy amounted to $33.1 billion. According to amended allegations, claimed Exchange Act exposure now amounts to $68.4 billion.

Today, insurers of directors and officers face the gargantuan hurdle of controlling significant cost outlays and potential losses given the incentives of securities class action plaintiff and defense attorneys. Plaintiffs attorney awards are based on a percentage of the settlement amount, and legal defense fees are determined based on the complexity of the case.

Lawyers on both sides stand to attain significant economic benefits from exceedingly long class periods. Insurers can begin to control litigation costs by pressing counsel on poorly supported class period start dates in securities class actions that allege violations of the Exchange Act.

It is evident that directors and officers of publicly traded companies are operating under an increasingly challenging risk environment.[9] Primary carriers are suffering significant margin compression from unforeseen macroeconomic factors and multiforum Exchange Act and Securities Act class action litigation.

Carrier profitability has decreased given the significant rise in claim severity across the property and casualty market. “The key driver of severity in excess liability claims is the courtroom, where large corporations are often the targets of higher-than-normal awards, in part due to the influence of younger generations on juries who tend to support bigger judgments,” according to Alicja Grzadkowska at Insurance Business magazine[10]

The current low-yield environment has also forced the costs of reinsurance capital to increase. “Big losses from 2017 and 2018, increased primary insurance rates in the United States and elsewhere, increased demand for reinsurance and low interest rates suppressing investment income all factor into what are expected to be modest average reinsurance rate hikes,” according to Gavin Souter at Business Insurance.[11]

It has now become necessary for all professional executive liability practitioners — underwriters, claims professionals, brokers, agents and risk management professionals — to focus on being better informed and more knowledgeable about exposures in order to keep directors and officers apprised of changes in claim severity stemming from securities class actions.

Insurers of directors and officers are well served by tracking and evaluating changes in class period intervals to track claim severity throughout the securities class action litigation life cycle.

Aggregate damages and defense costs are correlated with the length of the operative class period due to the hourly billing structure of the legal profession. A claim with a longer class period creates a greater exposure and requires significantly greater resources to defend given the length of time that spans between the alleged misstatements and the corresponding alleged corrective disclosures.

The greater the interval between the alleged misstatements or omissions and the alleged corrective disclosures, the more costly testing the relatedness among them becomes.

Severing the link of relatedness is one sure way of limiting severity to reduce costs of defending securities class action claims.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

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